The Power Of Tax Deferral In A Self-Directed Account
When we’re talking about your tip on a lunch out, 20% hardly seems worth discussing (especially if the service is good).
When we’re talking about your retirement accounts, 20% could mean hundreds of thousands (even millions) of dollars more in your retirement accounts.
To that end, I want to talk about a concept specific to the placement of your accounts. By placement, I mean whether you own your investments inside of a tax-deferred investment account such as an IRA or 401k, and/or a taxable brokerage account.
We drink our own kool aid, and make sure our own employees are educated on this kind of thing for their own portfolios, so let’s take two individuals on my team at Rocket Dollar as example—just for the fun of it. Ryan and Krista, both on our engineering team here, invest $100,000 each, watch it grow for 20 years, and both earn 7% consistently year over year.
The difference between them is that Krista has a tax-deferred account and will actually have a $136,874 increase in value over Ryan who owns the account in the taxable brokerage account.
Even if Krista were to withdraw that money, she’s going to have to pay the taxes somewhere down the road, but it would still only be $90,000 in taxes, netting almost $50,000 better than the Ryan owning the exact same investment in a taxable account.
Now that we’ve illustrated in real dollars how tax-deferred accounts can benefit your retirement savings greatly, we can explore a real option for those looking to invest, while also maintaining a tax-deferred vehicle for those same dollars. The increasingly common path for many is “self-directed” investment accounts.
Portfolio Catalyst: Self-Directed Investments
Krista is a savvy investor; she knows she needs to diversify her investments to help manage risk, but the traditional 80-20 equity/debt allocation model (Krista’s in her 30’s so she’s still mostly in public stocks) won’t cut it anymore. Recent market changes, including the rise of Exchange-Traded Funds and the increasing use of high-frequency trading (HFT) strategies, have created an environment where the traditional approach to diversification isn’t going to protect an IRA from a recession.
Krista needs additional tools to help manage her risk more than ever before. This is where a Self-Directed IRA comes in handy.
Since 1975, the IRS has allowed investors to use their IRA funds to invest in real estate, private equity, precious metals, and other private investments (also often called “alternative investments”). These alternative assets are foreign to the average investor, but Ivy League schools like Yale have been diversifying their endowments into leveraged buyouts, private debt and equity, natural resources, real estate and, in doing so, have earned an 11.3% investment return in 2017. Yale’s portfolio asset allocation model has been adopted by many other institutional investors around the world.
Many of these investments are with private companies, which carry their own sets of risks, but their performance is likely to have less to do with global or market conditions. Consequently, the returns are not correlated to the public markets, and, quite often, can provide a counterbalance to market conditions.
One way to consider alternative investments is this: you can invest in things you can see, know, and trust as opposed to trusting a Fortune 500 CEO that you have never met, or a fund whose investments you have no control over.
In the case of Krista, she can invest in something she knows intimately, such as a new FinTech startup. She can meet the CEO, the development team, and even serve as an advisor if the startup is looking for some help. Krista (like many investors) happens to be someone who feels more comfortable investing in a product she knows and a team who she genuinely thinks can succeed.
Generally speaking, investors can now choose to invest locally, an increasingly common approach, in a company whose products make sense to them. Investors, it seems, are insulating their overall portfolios from public market volatility by using this strategy.
Just imagine what a tax-deferred Self-Directed IRA could do for you in 20 years.